Prisoners of Our Own Device

The Dodd bill, just released by the Senate Banking Committee, would impose extensive new restrictions on the provision of financial services in the United States. These restrictions represent a fair price to pay for institutions that desire government backing, but they may prove insufficiently effective and unnecessarily stifling to companies that would prefer to go without government support.

To illustrate this point, consider what has come to be known as the Hotel California Provision, under which bank holding companies that have received TARP funds would be unable to avoid Federal Reserve supervision even if they eliminated their banks. In the words of the iconic pop lyrics: "You can check out any time you like, but you can never leave."

This sentiment goes beyond the single provision. The Dodd bill would create a Financial Stability Oversight Council to monitor not only banks that accept insured deposits but any financial company that posed a risk to the financial stability of the country. There would be no escape and the regulation would be substantial.

The Oversight Council would recommend to the Federal Reserve rules for capital, leverage, liquidity, and risk management. These rules would include restrictions on the investments of regulated institutions, banks and nonbanks alike, which would not be permitted freely to invest in hedge or private equity funds (the so-called Volcker Provision). Where a substantial risk to financial stability could be avoided in no other way, the Council could require the break-up of large firms. Even if they survived the Council's ax unscathed, regulated companies would also be required to pay billions of dollars into a fund designed to cover losses should the government need to intervene and guarantee the obligations of a failing institution large enough to threaten the nation's financial health. Where necessary, the FDIC would oversee an orderly liquidation of such a company.

The stated objective of these and other provisions, some shared with legislation recently passed by the House, is to discourage excessive growth and complexity in financial institutions and to manage the failure of those firms that founder despite the regulation. The idea is that too big to fail is simply too big.

The government should, of course, regulate any entity that it also insures. Just as the issuer of a fire insurance policy sensibly conditions coverage on the removal of flammable liquid from the insured premises, the government should not guarantee loans taken by financial institutions that are free to gamble away their assets. This principle applies to implicit as well as implicit insurance. The irresponsible bets taken by AIG prior to the financial crisis of 2008 were not expressly guaranteed, but when the government decided that AIG could not be allowed to go under, the taxpayers footed the bill anyway. It should be a goal of any reform to prevent a repetition of this debacle.

The question, though, is whether the best cure is to extend explicit insurance, and consequent regulation, rather than to truncate the implicit insurance. Both the Dodd bill and the House legislation opt for the former approach, but there is reason to prefer the latter.

The savings & loan crisis of the 1980s as well as commercial bank involvement in the most recent meltdown teaches us that even regulated institutions find ways to gamble excessively with other people's money and so an extension of the insurance model may exacerbate rather than ameliorate the risk to the public weal. And although some institutions grow too large, become too complex, and take on too much risk even from the narrow vantage point of their investors, there are potential benefits from size, innovation, and the willingness to lose.

A law that prohibited the use of government funds to bail out nonbank institutions--though unavoidably subject to change by future legislation--might signal to future investors that they should proceed with caution before committing funds to the next risky venture. That is, if the government withdraws from the private investment sector, the market might have a chance to discipline itself.

This is not to say that there is no room at all for government intervention. It would be reasonable, for example, to hold bank holding companies liable for the obligations of their deposit-taking subsidiaries; this would be a reasonable cost to incur in exchange for the subsidiaries' deposit insurance and could encourage the holding companies to better fund the subsidiaries, which would in turn have more money to lend businesses and consumers. Even those financial institutions that do no operate banks, and would thus not receive any form of direct insurance, could beneficially be required to keep transparent books for investors and to adopt liquidation plans in advance of failure--i.e., a living will--so that termination of investments in such firms can be swift and sure.

One might expect the market to demand the transparency and living will measures, but because rules on reporting and dissolution would not interfere with the fundamental risk and return calculus of a financial institution, regulation on these fronts to nudge the market along is unlikely to do much harm even if mistaken. Unfortunately, the same can't be said of the more draconian provisions of the pending legislation.

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The Dodd-Frank Act, signed into law in July 2010, represented the most significant and controversial overhaul of the U.S. financial regulatory system since the Great Depression. Forty NYU Stern faculty, including editors Viral V. Acharya, Thomas F. Cooley, Matthew P. Richardson, and Ingo Walter, provide a definitive analysis of the Act, expose key flaws and propose solutions to inform the rules’ adoption by regulators, in a new book, Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance (Wiley, November 2010).